Eye On Volatility: What's Your Duration?

The VIX’ trajectory may have turned, but volatility is still sky high…

As we commented on Nov. 4th, equity volatility appears to be showing signals that it is finally receding. Although it’s still too early to call, we have some data points to support this thesis:

• Despite several sharp intra-day spikes that brought it close, The VIX has still not clawed its way back to close over 67 since October 28th.• Since October 27th the VIX has closed below the realized 30 day volatility of the S&P 500 in every session. Remember that the VIX measures volatility implied by front month options, as such it indicates anticipated near term volatility. • VIX futures maturing in December and January hover still lower -near the 50 day moving average, indicating the boys in Chicago expect that equity volatility will start coming back closer to historical norms over the coming months. • Keith tracks the VIX in the same manner as he tracks cash indices and his models suggest that it runs out of bullish “Trade” momentum around the 70.94 levelEven if implied volatility levels are starting to decline however, they are still at historical high levels and provide both significant risks and opportunities.

Traders on the opposite tails of the investment spectrum (arbitrageurs and market-timing thrill seekers) will be looking to play this anticipated mean reversion in their own way. Those guys know what they are doing (or think they do), so I won’t waste any time on what strategies they may implement.

What I do want to underscore however, is that there are some very attractive opportunities for long/short and long only equity investors with mid and longer-term durations to capture value from the inflated premiums in the options markets right now. For the most part, these strategies will tend to fall into one of 2 categories: collecting premiums by selling expensive near term options in-line with a fundamental view on the underlying equity, or capturing longer-term directional exposure “cheaply” by exploiting steep implied volatility curves.

If any subscribers are interested, I would be happy to address specific strategies in the context of your portfolio. You can reach me at

Andrew BarberDirector

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11/16/08 11:20 AM EST

Quote Of The Week: George W. Bush

"The record is unmistakable: If you seek economic growth, if you seek opportunity, if you seek social justice and human dignity, the free market system is the way to go. And it would be a terrible mistake to allow a few months of crisis to undermine 60 years of success."-George W. Bush

With ole Bushy heading out the door, it's nice to see that he can get his words “unstuck” from time to time. This quote was from his speech at the Manhattan Institute earlier this week. I doubt he wrote it ... but it made me think of "The New Reality", nevertheless.

For any capitalist, it’s very hard not to appreciate the first part of the quote. If you genuinely want to be the change that you see needed in this world, you’re going to need the economic freedoms associated with a free market system. However, I would not mistake this “want” as one that Republicans alone can reserve as a special part of their “fiscally conservative” club membership. This is not the exclusive “want” of centrist Democrat capitalists either. This has always been the “want” of American Capitalists.

I have a problem with the assumptions imbedded in the second part of the quote. There is a gross duration mismatch here between rhetoric and reality. Unfortunately, this is going to be the hallmark of the Bush Administration’s failed management process. From the outset, they have managed the US Financial system reactively rather than proactively. Paulson and Co. are reacting to “a few months” of crisis, rather than having proactively prepared for it.

By my math, 60 years ago was 1948. You see, I take the President of the United States words quite literally… and there were a lot of American Capitalist battles won/lost in between then and now that laid the foundation for what we realists call “economic cycles.” Not all of these cycles have been good in the last 60 years. Not all of them bad. “The record is unmistakable.”

Hank Paulson’s last capitalist title was CEO of Goldman Sachs. While it would be hard to believe that the inspiration of his move to head the US Treasury was so he would not have to pay taxes (selling over $500M in GS stock, tax free), it would be even harder to believe that he left GS fully understanding the monster he helped create. Most of the financial leverage in our economic system was born out of the broker dealer SEC rules changing in 2004 (Bush de-regulation) which allowed firms like Goldman and Lehman to lever their brains out. Hank “The Market Tank” Paulson was one of the architects of this economic disaster.

The structural foundations of this “crisis” didn’t come out of nowhere a “few months ago”. It was only 28 months ago, in fact, that Bush signed off on Paulson’s Captaincy. As another Bush Captain, Donald Rumsfeld, proved in the end, managing crises that you help perpetuate is a loser’s game. Being unprepared is as much a capital mistake as being unaware.

It’s time to get real here. It’s time to position this economy for “The New Reality.” If American Capitalists seek being a part of it, they better demand wholesale changes to our economic leadership lineup, immediately.

Keith R. McCulloughCEO / Chief Investment Officer

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11/16/08 09:21 AM EST

Chart Of The Week: Shark Hunting

“This shark, swallow you whole. Little shakin', little tenderizin', an' down you go. And we gotta do it quick, that'll bring back your tourists, put all your businesses on a payin' basis. But it's not gonna be pleasant.”-Quint (Jaws, 1975)

Suffice to say, this week wasn't one for the faint of heart. Shark hunting never is…

If you're in the "all in US$ cash" camp, that and gold worked, closing +1.5% and +1% on the week, respectively. If you were in the shark infested waters with us, it was a full contact sport.

The chart below paints the lines where we made calls this week. "Beware Of The Squeeze" (11/12) played out twice over the span of a very volatile 48 hours. From 1PM on 11/13 to the closing bell, we saw a +10.5% squeeze in the SP500, then from 1PM on 11/14 we saw a milder version of the same, but a +4.5% two hour move in the SP500 nevertheless.

We issued 12 sell/short orders on the Hedgeye Portfolio on 11/14. Our get long for the squeeze call was not one that we were going to sit on forever. Just after 3PM on Friday, we issued a note calling out stiff shark bite resistance at SP500 920.KM

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Chinese are eating more food away from home

A USDA Foreign Agricultural report indicated ongoing studies reveal that Chinese food consumption away from home is more significant than anticipated. According to the report, “Consumption patterns in China are in a state of transition, particularly in rapidly changing urban areas. Income growth is allowing households to substitute vegetables, fruit, and livestock products for staple grains. More recently, consumers in China have begun selecting goods based on quality over price and quantity, and food consumed away from home is rising as well.”

Specifically, of the food consumed away from home, about 40% is consumed in cafeterias, 20% in restaurants, 10% in fast food venues and another 10% at small food stands. Meat is the leading food category that is consumed outside of the home with over 50% of household meat consumption occurring away from the home. Seafood is number two with over 30% of household consumption outside of the home and about 30% of drink purchases are for away from home consumption. The report goes on to show that these away from home consumption levels rise with increased income.

The obvious beneficiary of this shift toward more away from home consumption in China is YUM. China currently accounts for nearly 30% of YUM’s segment operating profit and the company expects this profit contribution to grow to 40% by 2017. A cultural preference for dining out will make it easier for YUM to achieve this goal. YUM’s China same-store sales slowed somewhat in 3Q08 on a sequential basis to 18% (from nearly 30% in both 1Q and 2Q), and the company is lapping a difficult 30% comparison in 4Q08. That being, said the company is well positioned to capitalize on China’s growing economy over time. As incomes rise, YUM will benefit as more people choose to dine out.

Starbucks is another company that is betting on China. SBUX expects that China will become its largest market outside of the U.S. and is, therefore, increasing its investments in its China operations. At the end of fiscal 2007, SBUX’s stores in China accounted for 8% of its International store base, and the company more than doubled its FY07 company-operated unit openings in China from the year prior. SBUX’s China business will be helped if the percent of drinks consumed outside of the home continues to grow beyond the 30% level.

LISTEN TO THE FINANCE GUYS

Unless G2E shows us a slew of must have new products, 1H 2009 slot sales are going to be ugly. Q2 seems to be the at risk quarter for a number of companies in terms of potential covenant violations. I don’t care what the casino slot managers are telling the slot companies, corporate CFOs are controlling the slot procurement process. Most slot Capex will be pushed back to 2H 2009, if not later.

Slot functionality exceeds the actual average life cycle of 5-6 years by at least 5 years. Slots don’t breakdown. If an operator needs liquidity, they will cut slot Capex. Delaying Capex is the number one consideration for CFOs as they prepare their 2009 budgets. As soon as their budgets are communicated to the slot companies, 2009 guidance should come down. Analysts haven’t yet embraced this reality. As we discussed in our 11/2 post, “CAPEX, COVENANTS, AND CORPORATE CONTROL”, they continue to project roughly 10% revenue growth for WMS and BYI and still positive revenue growth for the slot industry in 1H 2009.

If you don’t believe me, check out the following management YOUTUBE from the Q3 conference calls. Remember, slots comprise the largest portion of maintenance Capex.

BYD Q3 2008Question: “Do you think you maintenance is sub $100 million right now or can you get away with spending $80 million a year in maintenance?”

Answer: “We can probably at this point run the business sub $100 albeit some of the things that we opportunistically put off we will deal with in future quarters or in the following year.”

LVS Q3 2008My guess is that LVS may not buy a single replacement slot machine next year given its financial situation.

ISLE FQ1 2008Guiding $40 million in Capex for this fiscal year, which is about 30% below normal just for maintenance Capex. Next fiscal year will likely be even lower.

ASCA 3Q 2008“So I guess at this point in time, in that $40 to $50 million range of maintenance CapEx again for next year, obviously subject to change based on the economy.”

The midpoint of the range is 30% below normal levels even before the “based on economy” adjustment.

PENN 3Q 2008“Well I think maintenance CapEx next year should be between $75 and $80.”

The midpoint of the range is 36% below normal levels, and these guys have liquidity and are underleveraged!

PNK 3Q 2008Question: Is the $9 million in the quarter sustainable or will that go back up?

Answer: Between 9 and 10, but it was running as high as 11 for a while there. Look, we'd like to get it as low as we can but we're not going to do miracles here. In fact, let me step back. It's an interesting environment we're in, in a lot of ways, especially in the casino business. “A lot of our competitors are in pretty rough shape and we hear the same stories you have that their not buying a single slot machine this year, or their cutting their maintenance CapEx to the bone.”

Harrah’s 3Q 2008“Maintenance capital expenditure usually runs 4-5 percent of net revenue. That is being reduced to half of the normal amount or less.”

TRMP Q3 2008Question: I wonder if you can give us a little more clarity as to what minimum maintenance CapEx might be and a sense for what your minimum cage cash could be next year.

Answer: “The CapEx we're going to limit to only essential compliant or life safety issues. We're not anticipating any more than $10 million between the three properties next year for maintenance capital.”

Station CasinosThis bankruptcy candidate may not buy any replacement slots next year.

Not many of these will be sold in 1H next year

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